September 26, 2020

Cayman Islands judgment affects hedge funds of the Living Dead


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Four years after the onset of the financial crisis, tens of billions of dollars remain locked up in illiquid “zombie” hedge funds that suspended their redemptions in the darkest days of the meltdown.

Today, these funds produce little if any financial return for their fiduciaries while their administrators continue to coast along, sitting on fund assets without making any effort to liquidate and return their holdings — yet still collecting their management fees. Most investors believe they are powerless to do anything, yet that is not the case.

Recent offshore case law — relevant to tax-exempt institutional investors given their ability to invest funds registered in offshore jurisdictions like the Caymans Islands — recognises an investor’s right to seek a “just and equitable” windup of a fund when it has gone into lockup mode and ceased to take in new subscriptions or make redemptions. This can be a powerful tool, as public pension fund investors demonstrated recently by forcing the liquidation of a fund run by Fletcher Asset Management after Fletcher was found to be insolvent by a judge in the Caymans.

At the worst of the market turmoil in late 2008, an estimated $175 billion of capital was locked up in illiquid hedge funds, according to Hedge Fund Review. It is estimated that some $50 billion to $60 billion remains locked up in zombie funds, out of the reach of investors.

While fund managers’ assertions that they needed time to liquidate assets and return cash to investors might have been justified in the immediate aftermath of the financial crash, years later those claims have worn thin. Tired of sitting idly by while waiting for managers to redeem assets, fed-up investors are resorting to the courts to reclaim what is theirs.

Fintan Partners recently filed suit in New York against the fund manager Medley Capital over its refusal to make cash redemptions from the Medley Opportunity Fund. Late last year, Fintan sought to redeem its investment in Medley Opportunity, but the fund managers refused to honour the request. In its filing, Fintan argues that Medley’s refusal to honour its redemption request in cash represents a breach of contract under the terms of its original agreement with the fund.

The Delaware Chancery Court last year ordered a fund managed by Paige Capital Management to return a $40 million investment by the Lerner family, which owns the Cleveland Browns football team.

The court ruled that the Paige Capital managers did not have authority under the governing fund documentation to employ a redemption-stalling device, and had breached their fiduciary duty and acted solely to feather their own financial nest by ensuring the continued collection of their management fees. It ordered the managers to return the entire Lerner investment, plus interest and certain excess fees they had paid.

In the recent Cayman Islands case, two funds managed by Aris Capital invested in 2007 in another hedge fund formed to trade commodities, the Heriot African Trade Finance Fund Ltd. Aris put up nearly a quarter of the equity in the Heriot fund, which invested almost all of its capital in only two companies, a manganese producer and a cocoa manufacturer, both of which defaulted when the financial crisis struck a year later. In early 2009, Heriot suspended all redemptions by its fund holders.

Aris initiated legal proceedings to wind up and liquidate the Heriot fund, arguing that it had failed to file its financial statements in a timely manner and could no longer execute its stated investment strategy. Aris later amended its petition to assert that the Heriot fund had lost its “substratum” and was no longer viable.

Under English law, “loss of substratum” refers to a situation, in which a business can no longer carry out its intended operations or services in accordance with its governing documents. In simplest terms, think of a baker who has lost his oven, or a taxi driver without a driver’s license — or a hedge fund holding mostly illiquid assets and no additional capital to put to work for its investors.

The Cayman Grand Court sided with Aris in its decision issued Jan. 4, 2011, and ordered the liquidation of the Heriot fund. “It is impossible for the fund to carry on its original businesses in the sense that it will not make any new investments or enter into any new trade finance transactions,” the court said, noting that the hedge fund’s “temporary” suspension of redemptions was in fact permanent. It required the fund to be wound up in a “just and equitable” manner.

In the case of dormant entities like the Heriot fund, the Cayman court said that liquidation was justified because “it has become impractical, if not actually impossible, to carry on its investment business in accordance with the reasonable expectations of its participating shareholders, based upon the representations contained in its offering document.”

More recently, the Cayman Grand Court ordered liquidation of a locally registered fund run by Fletcher Asset Management after three Louisiana public pension funds brought a petition to wind up the Fletcher fund on “just and equitable” grounds.

The Louisiana funds had invested a combined $100 million in 2008 in an unusual deal in which Fletcher offered the funds a “guaranteed” minimum 12 percent annual return backed by the assets of other investors. (Hedge funds typically do not offer clients minimum returns.)

In March 2011, two of the pension funds sought to withdraw money from Fletcher, which responded to their requests with promissory notes, or i.o.u.’s. In June 2011, the three Louisiana funds requested to cash out their total initial investments and accrued earnings, a sum they said equaled $144.5 million, based on monthly statements they had received.

In ordering the windup and liquidation of the offshore Fletcher funds, the Cayman court found that the funds were insolvent on a cash-flow basis, and it appointed local insolvency specialists to serve as official court-appointed liquidators and to pursue claims on behalf of investors.

Cayman law does not apply to hedge funds domiciled in the United States or other locations. But since such a high percentage of funds are domiciled in the Caymans, the Aris and Fletcher rulings represent significant pro-investor case law.

Investors may have historically assumed they were helpless in wrenching capital back from zombie hedge funds. As these recent cases illustrate, that is not necessarily so, however.

With the assistance of legal and financial advisers, investors can leverage their rights to audit a hedge fund’s books and records, independently value portfolio assets and, in extreme cases, force a liquidation to recover assets.

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